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26.01.2015

Waiting for expectations – how will the oil supercycle end?

The oil price slump has come as a huge surprise for the market. The very scale of the phenomenon is astounding, of course, but what is really interesting is that although everyone knew about the spectacular upsurge in oil supply in the US, which lay at the root of the declining prices, it did not feature as a material factor in any price projections or scenario analyses prepared by prominent think tanks, including the International Energy Agency.

Naturally, the impact of America’s growing oil production on prices was mitigated by generally proportionate slumps in North Africa and Middle East, but what has fallen will eventually rise back again. At the same time, however, the prospect of low oil prices, which the consumers readily welcome, is a substantial challenge not only to the upstream sector, but also to renewable energy and nuclear power industries. Oil prices were expected to remain high due to prolonged geopolitical turmoil in oil-producing regions and the belief that OPEC, loath to see prices dip for budget reasons, would take action to prevent any excessive slumps. And because projections released by international organisations are tool for managing expectations, everyone would rather let sleeping dogs lie. Waiting was a preferable course of action. Maybe the dogs will not wake up?

But the dogs did wake up after all, causing all sorts of trouble. Most importantly, expectations that oil prices would remain high were crushed (including short-term and two-year projections) and we currently have nothing to put in their place. As OPEC has stopped intervening, the market is looking to the marginal costs of production to support oil prices. These, however, are not easy to determine, so the process might take a while. The obvious course of action is to turn to the American tight oil sector, which is suspected to be behind this state of confusion. The price pressure which has already become to affect the sector (which is much more sensitive to price changes than conventional production) brings to light a number of facts about it, such as that marginal costs tend to differ considerably between individual wells, some forty thousand of which are drilled each year. The discrepancy stems from the fact that the cost of a well is more or less the same in each case, but the output can fluctuate hugely. Some wells flow less than a hundred barrels a day, while other can yield more than a thousand. Falling prices hit risky undertakings first, including low-efficiency projects. Wells close down, yet no proportional changes in production follow. Instead, the consolidation within the sector gathers pace, driving marginal costs down. A similar thing happened when the price of shale gas on the US market forced out a large number of independent producers, which caused the number of wells to decline sharply. Despite that, gas production went up. OPEC, which is a material source of uncertainty, has not had its last word yet, and it is hard to say when the cartel is going to step in again. The country which can tip the scales is Saudi Arabia, which not only sits on top of the lion’s share of global unconventional oil reserves with low marginal costs, but also has financial reserves to keep it floating until the marginal barrel is found.

From a long-term perspective, the oil price slumps seen since mid-2014 mark the last stage of the oil supercycle, which IHS believes to have begun in 2000 with a demand boom and supply bottlenecks. At that time, oil demand was driven by rapid economic growth in China, which joined the International Trade Organisation at the end of 2001, becoming an appealing destination for transferring production. Supply bottlenecks, on the other hand, were a consequence of the prolonged period of low oil prices after the 1980 Iranian revolution. In the following years, the oil price continued to go down, and once oil became an exchange-traded commodity in 1988, its price hovered around USD 18/b in 1990–1999. The first stage of the supercycle came to an end in 2007, gradually progressing into the second phase (2005–2011), which was about breaking the supply barrier. At that time, the price of oil grew rapidly – from USD 55/b in 2005 to over USD 111/b in 2011. While oil prices fuelled fears that the fast-growing demand will outstrip supply, the brisk pace at which the prices rose opened the way for new and expensive deepwater drilling, horizontal drilling and fracturing technologies. The oil rush also inspired exploration efforts in geopolitically unstable areas, such as Central Africa. As a result, 2012–2014 saw an upsurge in oil and natural gas production from new sources outside OPEC, which marked the third phase of the cycle. The 10 years of uninterrupted price growth – from USD 38/b in 2004 to USD 109/b in the first half of 2014 (over USD 5 a year) – resulted in substantial and lasting reductions in demand in developed economies. Oil prices remained high throughout that stage of the cycle, reaching USD 112/b in 2012 and USD 109/b in 2013, and were further cemented in the first half of 2014 on the back of geopolitical developments and production slumps in North Africa and Middle East. The third stage of the supercycle took place at a time when the global economy oscillated between stagnation and weak recovery, and oil demand was additionally undermined by China’s protracted business cycle (bracing for the hard landing after government-sponsored stimulation of investment in infrastructure). This situation triggered, in mid-2014, the ongoing oil price slump.

The price slump ushered in the fourth phase of the cycle, which brought still lower prices as the oversupply of oil was being absorbed by the market and the search for the marginal barrel continued. The price decline will erode production potential, which will have to be adjusted to new pricing conditions. The adjustment process will not be a smooth transition for several reasons. Having lost the compass that OPEC’s strategy was, the market is now groping in the dark. The search for the marginal barrel has begun on the American market, progressing from the physical market (OPEC) to the paper market (NYMEX), which is much more volatile. Price projections on the latter market have a bearing on the capital market and affect the availability of financing for American upstream companies and their CAPEX as well as future production figures, which in turn shape future oil prices. The duration of the current phase of the cycle is uncertain. Taking into account the oil market’s structure (paper and capital market transactions are prevalent in the US) and technological considerations (production sector reacts quickly to changes in price expectations), experts estimate that it may last for one to three years. However, looking at past events, we will remember that the price decline and the subsequent stagnation of prices at low levels which followed the second oil shock in the wake of the Iranian revolution persisted for nearly two decades.

It is hard to say today what the price of oil will be in two or three years, but following the line of thought presented above we can expect that the future price trajectory will be lower than we had anticipated just half a year ago. At the same time, oil prices can be expected to be much more volatile than in the last three years. During adjustment periods, such as the one we are currently going through, price expectations are not unlike self-defeating prophecies. The greater the expected strength and duration of the price slump anticipated by the market, the quicker and stronger the future supply reductions will be (more and more production projects become unprofitable, financing becomes difficult to obtain). As a result, future supply shrinks even more, driving future prices beyond today’s expectations. Given the existence of such a mechanism, the market prefers to adjust its price expectations in small increments. In consequence, rather than portend a rapid increase, the steep contango seen in futures price graphs points to oversupply as the reason behind the current oil price dip.